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Capital
Budgeting
Learning Objectives
1. Define capital budgeting and discuss the characteristics
of capital investment decision. (CO1)
2. Identify the different capital budgeting concepts. (CO1)
3. Evaluate an investment project using the Net Present
Value method. (CO4)
4. Determine the acceptability of an investment project
using the internal rate of return method. (CO4)
5. Evaluate an investment project that has uncertain cash
flows. (CO4)
6. Rank investment projects. (CO4)
7. Compute for simple rate of return on an investment.
(CO4)
Capital Budgeting
the process of determining which
Capital Budgeting
Process
2 Broad categories
of capital budgeting
decisions:
1.Screening decision
2.Preference decison
l. Identifying Long-Term
Goals
Strategic Investment
Investments that would change the
very character of the firm.
Examples:
entering a new product market
acquiring or merging with
another company
establishing a major joint venture
expanding overseas
2 Elements of the
Environment
Strategic decisions
must take international
Tactical Investment
This involvesProposal
investment that would
ll. SCREENING
Managers identify how a capital budgeting
proposal will affect the firm.
Proposals can originate in a variety of ways.
Changes in the firms environment that
force the company to take action.
Consumers, competitors or governments
may change the firms product or market
situation, and the firm must respond with
proposals to meet this challenge.
Firms may search out opportunities on
their own initiative.
In this phase, it is useful to categorize
potential proposals as to whether they
reduce the firms cost or expand its
operations.
Types of Investment
Proposals
2. Vertical
III. EVALUATION
An economic analysis is conducted using
discounted cash flow analysis to
determine whether the proposal is
economically profitable.
Consists of three distinct activities:
estimating the cash flows from the various
proposals
identifying projects
applying objective criteria before accepting
or rejecting the idea
Different Proposals:
Complementary
proposals
Substitute proposals
Mutually exclusive
proposals
IV. IMPLEMENTATION
Here, the company makes the
required arrangements to take
on the new projects. The needed
capital should be made readily
available. The initial start-up
capital is called capital outlay
or net investment.
V. CONTROL
The firm must constantly
monitor the costs and revenues
provided by the project and
assess the extent to which the
actual figures deviate from the
forecasted values used in
capital budgeting decision.
Initial
investment
including
installation costs
Increased
working capital
needs
R&M and
Incremental
operating costs
Incremental
revenues
Reduction in
costs
Salvage value
Release of
working capital
Methods of Evaluation of
Investment Proposals
Those that do not
consider the time
value of money (nondiscounted method)
Payback period
method
Accounting rate of
return
Bail-out method
Payback reciprocal
Basics Consideration in
Capital Budgeting
Generation of investment proposals
Estimate of cash flows for the
proposals
Evaluation of cash flows
Selection of projects based upon an
acceptance criteria
Continued re-evaluation of investment
projects after their acceptance
Principles of Estimating
Cash Flows
1. Cash flows should be measured on an
incremental basis.
2. Cash flows should be measured on an after-tax
basis.
3. Changes in net working capital should be
included in the determination of cash flows.
4. All the indirect effects of a project should be
included in the cash flow calculation.
5. Sunk costs should not be considered when
evaluating a project.
6. The value of resources used in a project
should be measured in terms of their
opportunity costs.
Calculating Net
Investment
For new business:
New project cost
Add: Incidental expenses
Investment in initial NWC
Net investment
Illustrative Problem
(Uniform Cash Inflow)
Non-uniform Cash
Inflows
Year 5
6
7
8
P1,300,000
1,100,000
700,000
900,000
Sample
Problem:
Firms
desired payback period is 3
years and the investment proposal
requires an initial cash outflow of
P1M. What is
the payback
period?
After-Tax
Free cash
Year 1
Flow
P200,000
Year 2
400,000
Year 3
300,000
Year 4
300,000
Year 5
1,000,000
P1M
P1M
600,000
500,000
Year 2
400,000
500,000
Year 3
300,000
Year 4
200,000
Proj. A
Year
Discounted Payback
Period
Undiscount PVIFA Discount Cumulat
ed FCF
(1+i)-n
ed FCF
ive
Discount
ed FCF
-1,000,000
1,000,00
0
600,000
.8547
512,820
487,180
400,000
.7305
292,200
194,980
300,000
.6244
187,320
7,660
200,000
.5337
106,740
99,080
Accounting Rate of
TheaccountingReturn
rate of returnis an
Ave. investment =
(original
investment+residual value)/2
500,000
Salvage value
20,000
Estimated ANIAT
50,000
10 years
SARR = 10%
AARR =19.23%
Note: For evaluation purposes, under
the ARR method, the higher the rate the
Sample problem:
Assume the following data:
Investment needed for the project
1,800,000
Est. economic life
years
10
Operati Cumulati +
ve ACIAT Salvag
ng
ACIAT
e
Value
Cumulati Bailve
out
Cash
period
Flows
500,000 500,000
700,00
0
1,200,00
0
1,500,00
0
1,900,00
0
.75
At the
end of
year
Total
2.75
Payback Reciprocal
an opposite of the payback method
formula is ACIAT/net investment or
1/payback period.
This method has wide applicability but its
major limitations are the following:
Valid only when the useful life of the
project is at least 2x the payback period.
Assumes that the ACIAT are fixed over the
life of the project.
A better approximator than ARR when the
economic life is long and the time-adjusted
rate is large.
Uniform ACIAT
Assume an asset costs 150,000 and will
generate an annual net cash inflows after tax
of 50,000 per year for 5 years with a SV of
15,000 at the end of the 5th year. The
companys cost of capital is 20%.
PV of an
PV of cash
Year
ACIAT
annuity of
P1 at 20%
inflows at
20%
149,530.5
0
0-5
50,000
2.99061
15,000
.40188
Total
6,028.20
155,558.7
0
To compute for PV of
annuity
1 - (1+i)-n or
(1+i) / / =
i
Using scientific
calculator:
Value = (1+i)-n
PV = (1-value)/i
NPV (Uneven
ACIAT)
Assume the following information:
Est. net investment
100,000
Est. life 5 years
Salvage value
20,000
Est annual net cash inflows after tax:
Year 1 70,000
Year 2 50,000
Year 3 20,000
Year 4 15,000
Year 5 10,000
Desired rate of return
20%
ACIAT
PV of an annuity
of P1 at 20%
0-1
70,000
.83333
1-2
50,000
.69444
2-3
20,000
.57870
3-4
15,000
.48225
4-5
30,000**
.40188
PV of
**10,000 Total
+20,000
=
ACIAT
PV of ACIAT
58,333.00
34,722.00
11,574.00
7,233.75
12,056.40
Profitability Index
Also known as desirability index, present
value index, and benefit cost ratio
Provides a common basis of ranking
alternatives which require different amounts
of investment.
Determined by dividing the total present value
of ACIAT by the net investment
Projects are ranked starting with the project
with the highest index.
Only those with more than or equal to 1.00
will be eligible for further consideration since
those less than zero will not yield the desired
rate of return.
575,000
220,000
2
420,000
200,000
325,000
3
450,000
200,000
Year
1
2
3
Total PV
ACIAT x
PVF
ACIAT x .
833
ACIAT x .
694
ACIAT x .
579
Project A Project B
183,260
349,860
138,800
225,550
260,550
115,800
582,610
691,210
PI (A) = 582,610/575,000 =
1.013
Net investment w/ no SV
P300,000
Estimated life
years
18%
2.690
20%
22%
2.589
Model
Concept of Focus of
Recovery measurem
ent
Decision
Criteria
Net cash
inflows
liquidity
the shorter,
the better
Payback
reciprocal
Net cash
inflows
liquidity
the higher,
the better
Payback
bailout
Net cash
inflows
liquidity
the shorter,
the better
profit
profitability
the higher,
the better
Accounting
rate of
return
Model
Concept of Focus of
Recovery measurem
ent
Decision
Criteria
Net cash
inflows
liquidity
Positive =
accept
Negative =
reject
Profitability
index
Net cash
inflows
liquidity
> 1 = accept
< 1 = reject
Discounted
payback
method
Net cash
inflows
liquidity
the shorter,
the better
Internal rate
of return
Net cash
inflows
liquidity
the higher,
the better